Why the 10-year Treasury yield’s bounce back above 4% should be a warning for investors

`` A tug-of-war is playing out in the $29 trillion Treasury market. - AFP via Getty Images ``

A tug-of-war has erupted in the $29 trillion Treasury market, between investors who worry that cracks in the labor market could prompt the Federal Reserve to dramatically cut interest rates and those who fear that the central bank’s fight against inflation isn’t yet won. ``

That’s evidenced by the recent bounce in the 10-year Treasury yield BX:TMUBMUSD10Y above 4%, after the benchmark rate briefly dipped below the psychologically important threshold early last week. `` ``

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The 10-year yield was at 4.034% on Monday afternoon, signaling hesitancy among investors to buy longer-term U.S. debt at some of the lowest yields of this year. `` ``

Investors remain cautious ahead of the Fed’s two-day policy meeting, which ends Wednesday — after which Fed Chair Jerome Powell is expected to announce a 25-basis-point cut in short-term rates and provide an updated outlook on the economy. ``

“It’s just this hesitancy to chase yields lower by a lot of investors,” said Gennadiy Goldberg, head of U.S. rates strategy at TD Securities. Bond prices and yields move in opposite directions. ``

While the bond market has been volatile this year, Treasury yields have trended lower from six months ago, with the shorter-term 2-year rate BX:TMUBMUSD02Y tumbling a lot further than its 10-year counterpart, as the below chart shows. ``

But that hasn’t been the only move that matters in the Treasury market. ``

A highly popular trade among bond managers has been to bet on a steepening of the Treasury yield curve, in which the gap between shorter-dated and longer-dated yields widens. ``

That’s worked out pretty well lately, with the difference between the 10-year and 2-year yields reaching 65 basis points only a few weeks ago. That was the second-highest level since January 2022, topped only by a brief spike to 67 basis points during April’s tariff-based market shock. `` Traders have been betting on a steeper Treasury yield curve. - Federal Reserve ``

Kent Engelke, chief economic strategist at Capitol Securities Management, has been in the steepening camp, while others, including bond-trading giant Pimco, have expressed doubts about its further upside potential. ``

“I do believe the yield curve will steepen for a number of reasons,” Engelke said — pointing to inflation that has been increasing, the large U.S. fiscal deficit and attacks by the Trump administration on the Fed’s independence. ``

“We are spending way too much money,” Engelke added, noting that he wants Trump to stop talking about firing Fed officials while pressuring the central bank to lower short-term rates. “What the president is doing is setting a very dangerous precedent.”

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If the Fed’s credibility comes into doubt, it could cause investors to lose confidence, which could put further downward pressure on the dollar DXY and cause U.S. Treasury yields to push higher. On the flip side, a revamped Fed under Trump could be more willing to do whatever it takes to lower longer-term rates.

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Strategists at RBC correctly pointed out in early September that investors counting on a steeper Treasury yield curve could be in for a “bit of a pain trade” ahead of the Fed’s rate decision. The above chart also reflects the slight retreat in the yield curve’s steepening in recent days.

Soft landing?

Simon Dangoor, head of fixed-income macroeconomic strategies at Goldman Sachs Asset Management, sees the Fed as likely to make a series of “adjustment cuts” but not being forced to react to the beginning of a significant rise in recession risks.

Specifically, he expects a soft landing for the U.S. economy, despite recent cracks in the labor market. “It’s been a nice environment for the steepeners,” Dangoor said, but he also thinks the path forward “has gotten more complicated.”

In the stock market, the S&P 500 SPX and Nasdaq Composite COMP both claimed fresh record closing highs Monday on expectations that the Fed will cut rates, boosting equities and securing a soft landing for the economy.

This comes as the Fed appears more focused on the labor market than on inflation, said Amar Reganti, fixed-income strategist at Hartford Funds — though he also thinks it’s too soon to tell what impact tariffs might have on inflation.

“I think the market’s mistake is assuming the pass-through would happen all at once,” Reganti said of tariff costs. “We’ve been arguing that this is a nonlinear process. It can happen fast, slow and, perhaps, not at all.”

See:Why the Fed’s first rate cut in 9 months could derail the stock-market rally — and how investors can prepare

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